The P/E 10 ratio is a crucial metric for evaluating stock market health over the long term. This indicator employs inflation-adjusted earnings per share, averaged across a decade, to offer a clearer picture of market valuation, minimizing the distortion caused by transient economic shifts. Popularized by Nobel laureate Robert Shiller, this metric is sometimes referred to as the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio, highlighting its connection to smoothing out the cyclical nature of corporate profits.
The foundation of the P/E 10 ratio traces back to the insights of investment pioneers Benjamin Graham and David Dodd. They recognized that short-term market cycles could lead to irrational price-to-earnings ratios. To counter this, they advocated for using multi-year averages of earnings per share, spanning five, seven, or ten years, when assessing a firm's valuation. This approach provides a more stable and reliable measure, enabling investors to look beyond immediate market volatility and understand the underlying value trends.
To calculate the P/E 10 ratio, one must gather the annual earnings per share for a stock index, like the S&P 500, over the past decade. These historical earnings are then adjusted for inflation using the consumer price index (CPI) to reflect their value in current dollars. The average of these inflation-adjusted earnings is subsequently divided into the index's current level to arrive at the P/E 10 ratio. Historically, this ratio has shown significant variability, ranging from a low of 4.78 in December 1920 to a peak of 44.20 in December 1999, with an average of 17.1 as of August 2020. Research suggests that lower CAPE ratios often precede higher long-term returns from equities. However, this ratio is not without its critics, who point out that it does not always accurately predict market turning points, such as tops or bottoms.
The P/E 10 ratio stands as an invaluable tool for investors and analysts seeking a deeper understanding of market valuations beyond the immediate horizon. By considering a decade of inflation-adjusted earnings, it offers a buffered perspective against the noise of short-term economic fluctuations and cyclical profit variations. While it may not be a perfect predictor of market peaks or troughs, its systematic approach fosters a disciplined, long-term view of investment potential, encouraging prudent decision-making grounded in historical context and fundamental value.
